David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Amneal Pharmaceuticals, Inc. (NYSE:AMRX) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Amneal Pharmaceuticals's Debt?
As you can see below, Amneal Pharmaceuticals had US$2.79b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$304.8m in cash, and so its net debt is US$2.48b.
How Healthy Is Amneal Pharmaceuticals' Balance Sheet?
According to the last reported balance sheet, Amneal Pharmaceuticals had liabilities of US$667.3m due within 12 months, and liabilities of US$2.91b due beyond 12 months. Offsetting these obligations, it had cash of US$304.8m as well as receivables valued at US$662.8m due within 12 months. So its liabilities total US$2.61b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$1.34b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Amneal Pharmaceuticals would probably need a major re-capitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 5.7 hit our confidence in Amneal Pharmaceuticals like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Looking on the bright side, Amneal Pharmaceuticals boosted its EBIT by a silky 74% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Amneal Pharmaceuticals can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Amneal Pharmaceuticals actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our View
We feel some trepidation about Amneal Pharmaceuticals's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Amneal Pharmaceuticals's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example Amneal Pharmaceuticals has 4 warning signs (and 1 which is significant) we think you should know about.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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